MA 6e PPT Ch11 IE NEW

CORNERSTONES
of Managerial Accounting, 6e
CHAPTER 11:
FLEXIBLE BUDGETS AND
OVERHEAD ANALYSIS
Cornerstones of Managerial
Accounting, 6e
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
Learning Objectives
1. Prepare a flexible budget, and use it for
performance reporting.
2. Calculate the variable overhead variances, and
explain their meaning.
3. Calculate the fixed overhead variances, and
explain their meaning.
4. Prepare an activity-based flexible budget.
Using Budgets
for Performance Evaluation
 Budgets are useful for both planning and control,
where they are used as benchmarks for
performance evaluation.
 Determining how budgeted amounts should be
compared with actual results is a major
consideration that must be addressed.
LO-1
Static Budgets versus
Flexible Budgets
 A performance report compares actual costs
with budgeted costs. There are two ways to make
this comparison:
 Compare actual costs with the budgeted costs for the
budgeted level of activity (static budget).
 Compare actual costs with the actual level of activity
(flexible budget).
LO-1
Relationship: Static and Flex Budget Variances: Actual Quantity Produced
LO-1
Static Budget
 A static budget is a budget created in advance
that is based on a particular level of activity.
 Master budgets are generally created for a
particular level of activity.
 One way to prepare a performance report is to
compare the actual costs with the budgeted costs
from the master budget.
LO-1
Cornerstone 11.1
Performance Report Based on a Static
Budget: Budgeted Production
LO-1
Cornerstone 11.1
Performance Report Based on a
Static Budget: Budgeted Production (cont.)
LO-1
Flexible Budget
 A flexible budget enables a firm to compute
expected costs for a range of activity levels.
 The key to flexible budgeting is knowledge of
fixed and variable costs.
 The two types of flexible budgets are:
 Before-the-fact, in which the budget gives expected
outcomes for a range of activity levels
 After-the-fact, in which a budget is based on the actual
level of activity
LO-1
Cornerstone 11.2
Preparing a Before-the-Fact
Flexible Production Budget
LO-1
Cornerstone 11.2
Preparing a Before-the-Fact
Flexible Production Budget (cont.)
LO-1
Cornerstone 11.3
Preparing a Performance Report
Using a Flexible Budget
LO-1
Cornerstone 11.3
Preparing a Performance Report
Using a Flexible Budget (cont.)
LO-1
Flexible Budget Variance
 A difference between the actual amount and the
flexible budget amount is the flexible budget
variance.
 The flexible budget provides a measure of the
efficiency of a manager.
 That is, how well did the manager control costs
for the actual level of production?
LO-1
Flexible Budget Variance (cont.)
 To measure whether or not a manager
accomplishes his or her goals, the static budget is
used.
 The static budget represents certain goals that
the firm wants to achieve.
 A manager is effective if the goals described by
the static budget are achieved or exceeded.
LO-1
Flexible Budgeting for Entertainment
LO-1
Variable Overhead Analysis
 In a standard cost system, the total overhead
variance, or the difference between applied and
actual overhead, is also broken down into
component variances.
 There are several methods of overhead variance
analysis; the 4-variance method is described in
this chapter.
LO-2
Variable Overhead Analysis (cont.)
 First, overhead is divided into fixed and variable
categories. Next, two variances are calculated for
each category.
 Variable overhead variances
 Variable overhead spending variance
 Variable overhead efficiency variance
 Fixed overhead variances
 Fixed overhead spending variance
 Fixed overhead volume variance
LO-2
Total Variable Overhead Variance
 The total variable overhead variance is the
difference between the actual variable overhead
and applied variable overhead.
 VOH is applied by using hours allowed in a
standard cost system.
 The total variable overhead variance can be
divided into spending and efficiency variances.
 Variable overhead spending and efficiency
variances are calculated by using either the
three-pronged (columnar) approach or formulas.
LO-2
Variance Abbreviations
 Because the equations for variable overhead
variances can be long if expressed in words,
abbreviations are often used.
 Here are some common abbreviations:
LO-2
Cornerstone 11.4
Calculating the Total Variable Overhead
Variance
LO-2
Variable Overhead Spending Variance
 Variable overhead spending variance

measures the aggregate effect of differences
between the actual variable overhead rate
(AVOR) and the standard variable overhead rate
(SVOR).
 The actual variable overhead rate is computed as

follows:
LO-2
Variable Overhead Efficiency Variance
 VOH is assumed to vary in proportion to changes

in the direct labor hours used.
 Measures the change in the actual variable
overhead cost (VOH) that occurs because of
efficient (or inefficient) use of direct labor.
 The variable overhead efficiency variance is
computed by using the following formula:
LO-2
Cornerstone 11.5
Variable Overhead Spending,
Efficiency Variances: Columnar & Formula
LO-2
Cornerstone 11.5
Variable Overhead Spending, Efficiency
Variances: Columnar & Formula (cont.)
LO-2
Cornerstone 11.5
Variable Overhead Spending, Efficiency
Variances: Columnar & Formula (cont.)
LO-2
Comparison: Price Variances of
Materials and Labor
 While the variable overhead spending variance is
similar to the price variances of materials and
labor, there are some conceptual differences.
 VOH is not a single input—it is made up of a
large number of individual items.
 The standard variable overhead rate represents
the weighted cost per direct labor hour that
should be incurred for all variable overhead
items.
LO-2
Materials and Labor (cont.)
 The difference between what should have been
spent per hour and what actually was spent per
hour is a type of price variance.
 One reason that a variable overhead spending
variance can arise is that prices for individual
variable overhead items have increased or
decreased.
LO-2
Materials and Labor (cont.)
 The second reason for a variable overhead
spending variance is the use of the items that
comprise variable overhead.
 Waste or inefficiency in the use of VOH increases
the actual variable overhead cost.
 The variable overhead spending variance is the
result of both price and efficiency.
LO-2
Responsibility for the Variable
Overhead Spending Variance
 Variable overhead items may be affected by
several responsibility centers.
 If consumption of VOH can be traced to a
responsibility center, it can be assigned.
 Controllability is a prerequisite for assigning
responsibility.
LO-2
Overhead Spending Variance (cont.)
 Price changes of variable overhead items are
essentially beyond the control of supervisors. If
price changes are small, then the spending
variance is primarily a matter of the efficient use
of overhead in production.
 Responsibility for the variable overhead spending
variance is generally assigned to production
departments.
LO-2
Overhead Efficiency Variance
 The variable overhead efficiency variance is
directly related to the direct labor efficiency or
usage variance.
 If variable overhead costs change in proportion to
changes in direct labor hours
 Responsibility for the variable overhead efficiency
variance should be assigned to the individual who
has responsibility for the use of direct labor: the
production manager.
LO-2
Performance Report: Variable
Overhead Spending, Efficiency Variances
 Recall that Cornerstone 11-5 showed a favorable
$45 variable overhead spending variance and an
unfavorable $30 variable overhead efficiency
variance.
 The $45 F spending variance means that less was
spent than expected on variable overhead.
 The reasons for the $30 U variable overhead
efficiency variance are the same as those offered for
an unfavorable labor usage variance.
 Control of VOH requires line-by-line analysis for
each item. LO-2
Cornerstone 11.6
Preparing a Performance Report for the
Variable Overhead Variances
LO-2
Cornerstone 11.6
Preparing a Performance Report for
the Variable Overhead Variances (cont.)
LO-2
Fixed Overhead Analysis
 Fixed overhead costs are capacity costs acquired
in advance of usage.
 The fixed overhead rate changes as the
underlying production level changes.
 To keep a stable fixed overhead rate throughout
the year, companies typically use practical
capacity to determine the number of direct labor
hours in the denominator of the fixed overhead
rate.
LO-3
Total Fixed Overhead Variances
 The total fixed overhead variance is the
difference between actual fixed overhead and
applied fixed overhead.
 When applied fixed overhead is obtained by
multiplying the standard fixed overhead rate
(SFOR) times the standard hours allowed for the
actual output (SH).
LO-3
Total Fixed Overhead
Variances (cont.)
 The total fixed overhead variance is the
difference between the actual fixed overhead and
the applied fixed overhead:
LO-3
Cornerstone 11.7
Calculating the Total Fixed Overhead
Variance
LO-3
Fixed Overhead Spending
Variance
 The fixed overhead spending variance is defined
as the difference between the actual fixed
overhead (AFOH) and the budgeted fixed
overhead (BFOH):
LO-3
Fixed Overhead Volume
Variance
 The fixed overhead volume variance is the
difference between budgeted fixed overhead
(BFOH) and applied fixed overhead:
 The volume variance measures the effect of the

actual output differing from the output used at the
beginning of the year to compute the
predetermined standard fixed overhead rate.
LO-3
Fixed Overhead Volume
Variance (cont.)
 If you think of the output used to calculate the
fixed overhead rate as the capacity acquired
(practical capacity) and the actual output as the
capacity used, then the volume variance is the
cost of unused capacity.
LO-3
Cornerstone 11.8
Calculating Fixed Overhead Variances:
Columnar and Formula
LO-3
Cornerstone 11.8
Calculating Fixed Overhead Variances: Columnar and
Formula (cont.)
LO-3
Cornerstone 11.8
Calculating Fixed Overhead Variances: Columnar and
Formula (cont.)
LO-3
Responsibility for the Fixed
Overhead Spending Variance
 Many fixed overhead items—long-run
investments can be changed in the short run.
 Fixed overhead costs are often beyond the
immediate control of management.
 Many fixed overhead costs are affected primarily
by long-run decisions, and not by changes in
production levels, the budget variance is usually
small.
LO-3
Analysis of the Fixed Overhead
Spending Variance
 Because FOH is made up of many individual
items, a line-by-line comparison of budgeted
costs with actual costs provides more information
concerning the causes of the spending variance.
 An investigation might reveal that these are due
to issues beyond management control like the
weather.
LO-3
Responsibility for the Fixed
Overhead Volume Variance
 Volume variance measures capacity utilization
which implies that the general responsibility for
this variance should be assigned to the
production department.
 A significant volume variance may be due to
factors beyond the control of production.
LO-3
Analysis of the Volume Variance
 Notice that the volume variance occurs because
fixed overhead is treated as if it were a variable
cost.
 In reality, fixed costs do not change as activity
changes, as a predetermined fixed overhead rate
allows.
LO-3
Analysis of the Volume
Variance (cont.)
LO-3
Activity-Based Budgeting
 The traditional approach to budgeting
emphasizes:
 estimation of revenues and costs by organizational units
(e.g., departments, plants)
 use of a single unit-based driver such as direct labor
hours
 Companies that have implemented an activity-
based costing (ABC) system may also install an
activity-based budgeting system.
LO-4
Activity-Based Budgeting (cont.)
 An activity-based budgeting (ABB) system
focuses on:
 estimation of the costs of activities rather than the costs
of departments and plants
 use of multiple drivers, both unit-based and nonunit-
based
LO-4
Static Activity Budgets
 Assuming that activity-based costing (ABC) has
been implemented:
 ABB estimates the workload (demand) for each
activity and then determining the resources
required for this workload.
 ABB begins with sales and production budgets.
 Direct materials and direct labor budgets are also
compatible with an activity-based costing
framework and can be traced to the individual
products.
LO-4
Static Activity Budgets (cont.)
 The major differences between traditional and
ABB are found in the overhead and selling and
administration categories.
 In a traditional-based approach, budgets within
these categories are typically detailed by cost
categories.
 Traditional budgets are constructed by budgeting
for a cost item within a department and then
rolling these items up into the master overhead
budget.
LO-4
Static Activity Budgets (cont.)
 ABB identifies the overhead, selling, and
administrative activities.
 Then builds a budget for each activity, based on
the resources needed to provide the required
output levels.
 Costs are classified as variable or fixed with
respect to the activity output measure or driver.
LO-4
Cornerstone 11.9
Preparing a Static Budget for an Activity
LO-4
Cornerstone 11.9
Preparing a Static Budget for an Activity
(cont.)
LO-4
Activity Flexible Budgeting
 Understanding the relationship between changes in
activity costs and changes in activity drivers allows
managers to more carefully plan and monitor
activity improvements.
 Activity flexible budgeting is the prediction of
what activity costs will be as related output
changes.
 Variance analysis within an activity framework
makes it possible to improve traditional budgetary
performance reporting, and enhances the ability to
manage activities. LO-4
Activity Flexible Budgeting (cont.)
 If costs vary with respect to more than one driver,
and the drivers are not highly correlated with
direct labor hours, then the predicted costs can
be misleading.
 The solution is to build flexible budget formulas
for more than one driver.
 Cost estimation procedures (high-low method, the
method of least squares, and so on) can be used
to estimate cost formulas for each activity.
LO-4
Cornerstone 11.10
Preparing an Activity Flexible Budget
LO-4
Cornerstone 11.10
Preparing an Activity Flexible
Budget (cont.)
LO-4
Cornerstone 11.10
Preparing an Activity Flexible
Budget (cont.)
LO-4
Cornerstone 11.11
Preparing an Activity-Based Performance
Report
LO-4
Cornerstone 11.11
Preparing an Activity-Based Performance
Report (cont.)
LO-4
Activity Flexible Budgeting for Museums
Museums do much more than simply present art to the public. Today’s art
museums put on shows, provide access to the public to view the collections, sell
art-related merchandise in the museum store and online, and may put on special
events and performances. The annual budget for a museum can easily run into
millions of dollars, so cost understanding and control are crucial. As an
accountant for a large metropolitan museum, you would be responsible for
budgeting and controlling costs. Splitting costs into fixed and variable components
would be a first step in budgeting. However, what driver would you use? Number
of patrons going through the museum? That would be a good driver for a few
costs, especially those related to printing tickets and explanatory materials (such
as maps of the museum to help people navigate through the collections).
However, the vast majority of costs would be fixed with respect to the number of
people going through the museum. ABC and budgeting would give a much richer
view of the costs of running the various activities of the museum.
What type of information would you need to create activity-based budgets?
LO-4
Activity Flexible Budgeting for
Museums (cont.)
Your first step would be to determine the various activities of the museum. These
might include: providing access to the public, selling merchandise through the
museum store, putting on special events (e.g., concerts, lectures, benefits),
acquiring and cataloging pieces of art, and so on. For example, the activity of
cataloguing new art pieces would include the salaries of staff who catalog the
pieces, or clean and restore them, insurance on the art, and so on. Many of these
costs vary with the number of newly donated or purchased pieces. The activity of
selling merchandise would have costs of staff to run the store, cost of the items
purchased for sale, advertising, and so on. Those costs might vary with the
number of items sold or with the revenue earned. Putting on special events would
have a different set of costs attached and those might vary with the number of
events and the number of attendees.
Recognizing the different activities associated with the museum and
relating the costs to specific activity drivers will give you a much better idea
of what costs to expect. This understanding can help the museum director
exercise good stewardship of the funds donated and provide important
services to the public. LO-4

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CORNERSTONES

 Variable overhead spending variance

 The actual variable overhead rate is computed as

 VOH is assumed to vary in proportion to changes

 The volume variance measures the effect of the

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